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July 2004
TABLE OF CONTENTS
TABLE OF CONTENTS ............................................................................................... 2 INTRODUCTION .......................................................................................................... 3 TRADING ....................................................................................................................... 4 SALES ........................................................................................................................... 12 ETHICS......................................................................................................................... 16 LEGAL ISSUES ........................................................................................................... 19 RISK MANAGEMENT ............................................................................................... 21 OPERATIONS.............................................................................................................. 24 HUMAN RESOURCES ............................................................................................... 27 OTHER ISSUES........................................................................................................... 30 ADDENDUM A ............................................................................................................ 32 ADDENDUM B............................................................................................................. 36 ADDENDUM C ............................................................................................................ 40 ACKNOWLEDGMENTS............................................................................................ 43
This document and others published by the Committee are available on the Committees web site, <www.newyorkfed.org/fxc>.
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INTRODUCTION
The development and dissemination of useful trading practice guidelines are key priorities of the Foreign Exchange Committee. With the distribution of these new Guidelines, the Committee seeks to: provide all participants in the wholesale foreign exchange community (individuals and firms, intermediaries and end users) with a common set of best practices that will assist them in conducting their business activities, promote discussions about practices that further market efficiencies and transparencies, highlight pertinent issues meant to facilitate informed decision making, and refer the global community to useful research materials and related initiatives of the Foreign Exchange Committee.1
The Committee published its first version of the Guidelines in 1979. As the industry evolved and trading processes changed, the Committee periodically updated the paper. This latest version, the Committee's fifth, revises a 1996 document and supercedes previous versions.
More information about the Committee, including its most recent annual reports, is available on its web site, <www.newyorkfed.org/fxc>. Foreign Exchange Committee Page 3
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TRADING
In this section: Time-proven best practices for all trading staff Safeguards to adopt when trading with your electronic broker Procedures for special trading practices, including historical rate rollovers, stop-loss orders, and switches Solutions for trade-related problems
The Committee targeted dealer and broker wholesale activity in its 1995 report, Principles and Practices for Wholesale Market Transactions. Because of recent market changes, portions of this report may appear dated. However, other sections, including those treating reliance on advice, confidentiality, and valuation, are still pertinent. Foreign Exchange Committee Page 4
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parties concerning their trades, their trading positions, or the firm's position. It is also inappropriate to disclose, or to request others to disclose,
information relating to a counterpartys involvement in a transaction except to the extent required by law. Institutions should develop policies and procedures
governing the internal distribution of confidential information. Trading room staff should take special precautions to avoid situations involving or appearing to involve trading on nonpublic information. Be responsible in quoting prices. Staff responsible for dealing prices and authorized to quote such prices electronically or verbally should comply with all pertinent internal as well as generally accepted market practices. It is unethical (and in many cases illegal) to post firm prices for rate-fixing purposes without having a valid commercial intent to deal at those prices. Traders are expected to commit to their bids and offers for generally accepted market amounts unless otherwise specified or until a) b) c) the bid or offer is either dealt on or canceled, the bid or offer is superseded by a better bid or offer, or a broker closes another transaction in that currency with another counterparty at a price other than that originally proposed.
In the cases of (b) or (c), the broker should consider the original bid or offer invalid unless the dealer reinstates it.
For additional commentary and analysis on electronic trading, see the Committee paper, A Survey Assessing the Impact of Electronic Brokering on the Foreign Exchange Market, November 1997. The Committee also addressed electronic broking in its 1991 and 1994 Annual Reports. Foreign Exchange Committee Page 5
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Management must actively monitor the use of systems to ensure that staff is properly trained, disputes are identified promptly, and proper interaction exists with vendors. Procedures involving trade disputes should be documented and fully understood by all parties before any trades are executed. Participants should fully integrate electronic trading systems with their own internal processing systems to avoid exceeding credit and other risk limits. Firms should be fully aware of their system capabilities, including obligations of all offered services and potential liability if they fail to satisfy their obligations. Contingency, recovery, and security procedures should be continually assessed.
The importance of good judgment in a changing market Rules that govern customer confidentiality and privacy could be complicated when information on counterparty roles is shared with numerous financial institutions on the same electronic platform. Market participants should be alert to the possibility that the development of multiple, discrete electronic communication networks could fundamentally change the way the market operates. Organizations are encouraged to monitor relevant developments in electronic commerce and to devise appropriate responses and strategies.
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The Committees letter on historical rate rollovers, first published in December 1991, continues to offer sound advice to those who need to execute these transactions. The letter, reprinted in the Committees 1995 Annual Report, is available on the Committees web site, <www.newyorkfed.org/fxc>. 5 For detailed information on best practices and procedures for stop-loss orders, please visit the Committees web site for the Guide to the International Currency Options Market Master Agreement. This agreement was published in 1995 and was followed by a February 2000 revision to the barrier options guidelines and a new stop-loss template that was posted on the Committees web site in September 2000. The Committee offered additional recommendations in its 1997 letter: Handling stop-loss orders in an electronic trading environment. Foreign Exchange Committee Page 7
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These complexities may include conditional provisions, transaction notification, and cancellation or forwarding instructions. Stop Loss Order Definitions Stop loss orders typically fall into four classes although some dealers may offer products that vary in their structure and complexity. Some classes are more commonly used than others and dealers do not typically offer all classifications of stop loss orders. To varying degrees, each type of stop loss order balances the protection against the risk of slippage (the difference between the order level and the actual trade price) and the expense of an early exit from the trade position. While slippage is a function of liquidity at different price levels, it may be magnified or mitigated depending on the type of stop loss order used. All of these definitions apply to normal market amounts under normal market conditions. As always, a counterparty should ensure that it independently understands the parameters of normal market conditions that prevail for each currency market and can effectively recognize risks during abnormal market conditions. Bid/Offer stop The order is executed when the market bid(offer) price reaches the level indicated by the bid (offer) stop order. This stop loss order becomes an at best order (executed at the best price available), which may result in significant slippage in volatile market conditions. Example: Buy 10mio Eur at .90xx s/l BID - When the Euro bid price is at .90xx, the customers order will be filled at the next offer price. In this example, the order may be filled at a much higher price than the original order level, depending on the market liquidity at the time of the trade.
All taken/given next stop - The order is executed when the market is no longer offered (in the case of a buy stop) or bid (in the case of a sell stop) at the level indicated by the order. While this stop loss order becomes an at best order, the slippage may be less than a bid/offer stop under normal liquidity conditions. Example: Buy 10mio Eur at .90xx s/l All Taken Next When the Euro trades through all remaining .90xx offers, the customers order will be filled at the next available offer. It is not necessary for the market to be bid at .90xx.
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The order is executed if the order level trades in the market. It is only necessary for the level to trade once for the stop loss to be executed. This type of stop loss order may provide additional protection against slippage. However, it typically does not protect against the risk that the order may be executed even if the market price does not trade through the order level. Example: Buy 10 mio Eur at .90xx s/l One Touch - If the Euro trades at .90xx, the customers order will be filled at the next offer, including any remaining .90xx offers. In this example, the order fill may be closer to the order level than a bid/offer stop or an all taken/given stop order.
At price stop -
The order is typically a one touch stop where the dealer will guarantee, under normal market conditions, that the order fill will not exceed the level of the order. The customer typically faces the risk that the order may be executed even if the market price does not trade through the order level. It should be noted, however, that at price stops are not typically offered by all dealers given their implied guarantee. Example: Buy 10 mio Euro at .90xx s/l At Price - If the Euro trades at .90xx, the dealer will buy 10mio Euro. The dealer will sell 10 million euros to the client at .90xx regardless of where the dealer covers the position in the market. In this case the risk of slippage is born by the executing dealer given that the trade price may exceed the order level.
Name substitution or switches In the traditional foreign exchange market, the names of the institutions placing bids or offers with a broker are not revealed until a transaction's size and exchange rate are agreed on.6 Even then, only the counterparties receive this information. If one of the counterparties is unacceptable to the other, the substitution of a new counterparty may be agreed on. The procedures for such substitutions include the following:
6
both counterparties receive the name of an acceptable counterparty within a reasonable amount of time, the clearing bank is fully aware of the parties in the trade and the appropriate credit lines, and
The Committee published a letter in September 1993 outlining best practices for brokers switches. A summary of that letter was included in the 1994 Annual Report, page 6. Foreign Exchange Committee Page 9
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the clearing bank is operating in accordance with its normal procedures and limits.
An institution can minimize name substitution requests by providing a broker with the names of institutions it is willing to deal with or, alternatively, the names of the institutions it will always reject. A broker that proposes a transaction on behalf of an institution not usually regarded as an acceptable counterparty could also make the potential counterparty aware that the transaction may need to be referred to management for credit approval (that is, the counterparty may be "refer-able"). Name substitutions rarely occur in the brokered forward market. Participants in this market generally recognize and understand that a broker's forward bids and offers, even though firm, cannot result in an agreed upon trade at matching prices unless it comes within the internal credit limits of each counterparty. Forward dealers should not falsely claim a lack of credit to avoid trades or to manipulate prices. The allocation of counterparty credit lines to automated trading systems should be sufficient to support an institution's normal trading. Manipulation of credit lines to influence prices or transactions on such systems is unethical.
Many of these trade-related problems are addressed in Principles and Practices for Wholesale Market Transactions, published in the Committees 1995 Annual Report, pages 37-50. Foreign Exchange Committee Page 10
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Resolution Disputes, however, are inevitable, and management should establish clear and policies and procedures for resolution at the senior management level with a transparent audit trail. For example, in many markets difference checks are exchanged. Informal dispute resolution practices that sometimes develop in the market can be inconsistent with sound business practices. For example, the use of points is not an appropriate means of trade dispute resolution, and for some counterparties in some jurisdictions the use of points may be contrary to regulatory or supervisory guidance.8 Care must be taken that informal dispute resolutions are achieved through good faith, arm's-length negotiation. Differences should routinely be referred to senior management for resolution, a process that effectively shifts the dispute from the trading level to the institution. In addition, maintaining records of trades conducted through automated dealing systems or executed over the telephone can aid in resolving disputed transactions. Traders should not renege on a transaction, claiming credit line constraints, in an effort to "settle" a personal dispute. Instead, senior management should be made aware of a problem so that both counterparties may act to address and solve the issues. In all cases and at all times, traders should maintain professionalism, confidentiality, and proper language in telephone and electronic conversations with traders at other institutions. Reciprocity Two institutions may agree to provide timely, competitive rate quotations for marketable amounts on a reciprocal basis. However, because of changes in channels of distribution, the possibility of multiple prices in fragmented ECNs, and unpredictable oscillations in market liquidity, bilateral arrangements should be regularly revisited by trading room management. Management should analyze trading activity periodically. Any unusually large concentration of direct trading with an institution or intermediary should be reviewed to determine whether the level of activity is appropriate. Unintentional trades In an electronic brokering environment, unintentional trades may take place. Management of all trading parties should take steps to reduce the likelihood of unintentional trades. This can be accomplished when management assumes a key role in training new employees to deal with a voice broker or an electronic system.
The Committees guidance and recommendations on the use of points are included in the 1987 Annual Report (page 18), the 1988 Annual Report (pages 6-8), the 1989 Annual Report (pages 15-23), and the 1991 Annual Report (page 25). A U.S. regulatory policy statement prohibiting the use of points is included in the Committees 1990 Annual Report (page 28). Foreign Exchange Committee Page 11
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SALES
In this section: The crucial importance of knowing your customer When you should be suspicious of customer activities Appropriate actions when dealing with your customer Dealing with unnamed and undisclosed counterparties Watching out for money laundering
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Be on the alert for money laundering Management needs to be aware of the risks presented to an institution by money laundering. All applicable money-laundering laws, regulations, and industry guidelines must be strictly followed. Internal controls, including account openings, documentation procedures, and management information/monitoring systems, must be adequate to detect suspicious activity. Any irregular or suspicious activity needs to be communicated to management in a timely manner. Customer actions that should be viewed with caution include the following: large cash deposits the purchase or sale of large amounts of foreign currencies with the use of cash using accounts to clear large sums of money without an apparent business purpose needlessly maintaining large balances in non-interest-bearing accounts buying or selling securities with cash settling bearer securities outside of a recognized clearing system transacting securities with no discernible purpose unnecessary use of an intermediary unexpected repayment of a problem loan regular payment of large sums, including wire transfers, that cannot be explained in the context of the customer's normal business customers whose identity proves unusually difficult or expensive to verify use of an address that is not the customer's permanent business address (for example, utilization of a home address for business correspondence) customers who purposefully avoid needed contact with bank staff.
Relating to customers
Confidentiality and customer anonymity are essential to the operation of a professional foreign exchange market. Market participants and their customers expect that their interests and activity will be known only by the other party to the
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transaction (including accountants, lawyers, and other advisors on a need-toknow basis) and an intermediary, if one is used.9 It is inappropriate to disclose, or to request others to disclose, proprietary information relating to a customer's involvement in a transaction except to the extent required by law or upon the request of the appropriate regulatory body. Any exceptional request should be referred to management for review. Sales professionals need to assure themselves of a customer's authority to act (capacity), the authority of third parties (intermediaries) to act for the customer, and the authority of individuals to act for the customer or third party. Providing proper disclosures to ensure good client relationships It is acceptable for a salesperson to convey economic or market information, trading parameters, the institution's views, and personal views. It is not prudent for a salesperson to provide investment advice in the context of a dealing relationship unless this service is specifically contracted for or stipulated in writing. Sales staff should communicate effectively with clients to ensure that the clients have a full understanding of their trades. For complicated or structured transactions, the principal risks should be clearly identified for the client. It may be advisable to have transactions set forth in writing and a summary prepared of the transaction's principal risks, possible outcomes, and related cash flow information. Any such documents should include necessary disclaimers. Dealing with unnamed counterparties Trading foreign exchange on an unnamed basis refers to the practice whereby an investment manager trades on behalf of a client without revealing its identity to the dealer in order to maintain client anonymity.10 Such practices constrain a dealers ability to assess the creditworthiness of their counterparties and comply with know your customer and anti-money laundering rules and regulations. These conditions expose dealers to clear and significant legal, compliance, credit, and reputational risks, as well as heighten the risk of fraud. In addition, such practices pose a risk to the broader financial sector given the increased risk of fraud. It is recommended that investment advisors and dealers alike implement measures to eliminate the practice of trading on an unnamed basis.11
9
A thorough discussion of the concept of arms-length transactions is included in the Committee document, Principles and Practices for Wholesale Market Transactions. 10 Trading on an unnamed basis is often confused with trading on an undisclosed basis (when an intermediary does not explicitly acknowledge that it is acting as an agent at any point in the relationship). 11 A detailed discussion of the risks of unnamed counterparty trading is included in the Committee document, Information on Unnamed Counterparty Trading. The Committees guidance on the issue can be found in several letters to market participants available on the public website, www.newyorkfed.org/fxc. Other industry groups are also actively discouraging this practice in regional codes of conduct and best practices. The Bank of Englands Joint Standing Committee revised their Non-Investment Products Code, a reference source used for regulatory Foreign Exchange Committee Page 14
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Specifically, investment advisors and foreign exchange intermediaries should develop a process to disclose client names to a dealers credit, legal, and compliance functions prior to the execution of foreign exchange trades. In turn, dealers should establish procedures to ensure the strict confidentiality of the intermediarys clients and restrict the disclosure of this information to the front office except in the event of default. This could include a confidentiality agreement whereby the dealer agrees that only its credit, legal, and compliance functions will have access to the client name. The use of identification codes, or similar identifier systems, has been achieved in other markets. Accounting for customer block trades Investment advisors frequently bundle trades together for several clients (particularly in the case of mutual funds), later advising the institution with whom they are trading of the allocation among various clients (or funds). It is suggested that such allocations be done on a timely basis. It is also recommended that management adopt policies requiring that all transactions be allocated within some minimum period of time (for example, by the end of the business day). The credit department should be involved in any exceptions to this policy.12 Making sure all instruments are valued fairly From time to time, institutions receive customers' requests for portfolio valuations or pricing on specific outstanding financial contracts. It is important that any reported valuations not differ from what is posted on the institution's own books.13 It is the responsibility of a salesperson to determine whether the customer is requesting pricing for dealing purposes or for valuation purposes.14 At the same time, it is advisable to make appropriate disclosures when providing any information on pricing. Finally, it is recommended that any valuation be provided only after consultation with both senior management and the institution's legal department.
review of financial institutions and investment managers in the United Kingdom, to include best practices similar to those outlined above. 12 More detail on the process of allocating block trades is available in two Committee reports: Management of Operational Risks in Foreign Exchange (1995) and Foreign Exchange Transaction Processing: Execution-to-Settlement Recommendations for Nondealer Participants (1999). 13 This implies a specification of whether the posting is in bid-, mid-, or ask-prices. 14 Indicative basis quotes should be given either verbally or in writing with the appropriate disclosure. While an indicative quote may be used for evaluation purposes, it should not be understood as the price at which a firm would have dealt. Foreign Exchange Committee Page 15
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ETHICS
In this section: What management should do to create an ethical environment Policies on entertainment and gifts
Senior management should establish ethical standards governing the activities of trading and sales professionals to protect the institution's reputation with clients and counterparties. Dealing room staff must at all times conduct themselves with integrity.
Visitors
Managers should make sure proper confidential procedures are followed when there are visitors to the trading room. Visits should be prearranged and an employee should accompany all visitors. A visitor from another trading institution should not be permitted to trade for his or her own institution from the premises of the host.
For all staff, management should a) establish a code of conduct that conforms to applicable laws, industry conventions, and bank policies;
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b) c) d) e)
acknowledge the importance of maintaining the highest ethical standards; ensure that policies and procedures are well circulated and understood; periodically review ethics policies to ensure that they cover new products, business initiatives, and market developments; establish the proper oversight mechanisms for monitoring compliance and dealing swiftly and firmly with violations and complaints; and be alert to aberrant behavior, such as frequent involvement in disputes or acceptance of deals that are obvious misquotes.
f)
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scope for offering gifts and entertainment to customers recognizing the risks associated with excessive giving.
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LEGAL ISSUES
In this section: Why it is important to work closely with your compliance department Types of documentation that should be in place before trading with a customer
Market evolution, increased product sophistication, and technological advances have combined to make financial crimes more complex. The legal, regulatory, and reputation-related risks encountered by individuals and institutions active in financial markets have grown, and infractions are more difficult to detect. Awareness, training, and enhanced due diligence are management responsibilities that can help mitigate such risks. Management's specific policies and procedures should focus on money laundering, knowing your customer, fiduciary responsibility, and appropriateness (see the section on sales for more details). Compliance plays a key role in trading practices The legal and compliance departments support trading practices and procedures by identifying laws and regulations that apply to the foreign exchange business. Trading departments should familiarize themselves with the legal and compliance functions. Management should encourage fluid interaction between these two divisions. Specifically, a compliance department may support an institution by ensuring that programs conforming to applicable laws, rules, and obligations are implemented. Such support may include documenting and circulating appropriate policies and procedures and providing training to employees. observing operations, alerting management and trading staff to gaps in compliance, and providing leadership in addressing specific gaps and other compliance issues.
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Authority documents provide evidence of capacity-the right to enter into a transaction-and authority-permission for individuals to implement the capacity to act on behalf of a counterparty. Confirmations reflect economic ties agreed to in a transaction between the parties to a trade. The agreement covers the significant terms and conditions of the trades (see the 1998 FX and Currency Option Definitions, published by the Committee, the International Swaps and Derivatives Association, and the Emerging Markets Traders Association).15 Master Agreements contain terms that will apply to broad classes of transactions, expressions of market practice and convention, and terms for netting, termination, and liquidation. Other forms of documentation may include credit support documents, compensation agreements, margin agreements, and assignment agreements.
15
For certain types of transactionsfor example, a nondeliverable forward (NDF)confirmations play a more significant role in outlining the full extent of the transactions terms and conditions, including the impact of market disruption events. Foreign Exchange Committee Page 20
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RISK MANAGEMENT
In this section: What effective risk management requires Types of risk facing every foreign exchange trading business Suggestions for limiting risk
The goal of risk management is to ensure that an institution's trading, positioning, sales, credit extension, and operational activities do not expose the institution to excessive losses. The primary components of sound risk management include: a comprehensive risk measurement strategy for the entire organization, detailed internal policies on risk taking, strong information systems for managing and reporting risks, and a clear indication of the individuals or groups responsible for assessing and managing risk within individual departments.
The qualitative and quantitative assumptions implicit in an institution's risk management system should be revisited periodically. Risk management methodologies vary in complexity; the rule of thumb is that the sophistication of a risk management method should be commensurate with the level of risk undertaken by the institution. While systems and reports are elements of risk control, effective communication and awareness are just as vital in a risk management program.
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Settlement risk16 is specifically defined as the capital at risk from the time an institution meets its obligation under a contract (through the advance of funds or securities) until the counterparty fulfills its side of the transaction. Liquidity risk refers to the possibility that a reduction in trading activity will leave a firm unable to liquidate, fund, or offset a position at or near the market value of the asset. Operational/technology risk emanates from inadequate systems and controls, human error, or management failure. Such risk can involve problems of processing, product pricing, and valuation. Legal risk relates to the legal and regulatory aspects of financial transactions or to problems involving suitability, appropriateness, and compliance. In addition to these types of risk, there are also overall business risks such as reputation risk and fraud. Institutions and staff should also be aware of the risks associated with the accounting and tax treatment of transactions.
The Committees 1994 document, Reducing Foreign Exchange Settlement Risk, provides a detailed assessment of how to measure settlement risk and numerous suggestions to limit institutional exposure. While many of these suggestions have been implemented by the industry, others have yet to become common practice. Foreign Exchange Committee Page 22
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Applying risk management policies Independent valuation-model testing and approval process; independent approval and monitoring of customer credit limits and market risk position limits; exception reporting and independent approval of limit excesses; use of credit-related industry agreements, such as the Cross-Product Master Agreement. In all areas of an institution Contingency provisions can document and help regularly test disaster recovery and backup procedures involving both systems (front-, mid-, and back-office) and off-site facilities. Documentation procedures ensure the proper confirmation of all trades with a specific format chosen by the institution. New product development needs to be supported by approval and implementation procedures, including signoffs by legal, tax, audit, systems, operations, risk management, and accounting departments. In diversified institutions, market and credit risk can extend across departments, legal entities, and product lines, challenging both management information systems and documentation procedures. Management should develop discipline and experience in prudently managing the risk of transactions. Risks should be weighed against potential returns and long-term organizational goals. (Details on risk management-including definitions of risk measures, risk limits, and steps to improve a credit position-are included in Addendum A at the end of this document.)
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OPERATIONS
In this section: Sources for learning about operational best practices Some suggested actions when dealing with third-party transactions Requirements and benefits of netting
Operational risk may arise from unusual events, such as a natural disaster, or from ordinary occurrences-say, the differences in payment conventions between two trading partners. With increased use of technology, the prospect of electronic disruptions has emerged as a larger concern for all operational areas.
Deal confirmations
Trades with clients, counterparties or intermediaries, whether spot, forward or derivative transactions, should be confirmed as soon as possible after the terms of the trade are agreed. Same-day telephone confirmations should be followed with written confirmations in a timely manner using SWIFT messaging, faxing or secure electronic means. Prompt and efficient confirmation procedures are a
17
The Committee, supported primarily by the efforts of the Operations Managers Working Group, published Management of Operational Risks in Foreign Exchange in April 1996. The Committee released Foreign Exchange Transaction Processing: Execution-to-Settlement Recommendations for Nondealer Participants in November 1999. 18 Operations issues specifically related to collateralized transactions are addressed in the paper, Managing Operational Risk in Collateralized Foreign Exchange, published in 1997. Foreign Exchange Committee Page 24
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deterrent to unauthorized dealing. In addition, the sooner a trade problem in identified, the easier and often less expensive it is to resolve.
Finally, on the transaction date, operations staff should confirm the transaction and its specifics in a telephone conversation with the third-party individual identified by the counterparty.
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19
Guidelines for Foreign Exchange Settlement Netting, published by the Committee in 1996, includes passages that may not appear up-to-date (such as the details on available netting services) but the introduction, review of legal documentation, and discussion of the decision to net still provide timely information. 20 The Financial Markets Lawyers Group (FMLG), an industry organization of lawyers representing major financial institutions, helped draft netting agreements, including the International Foreign Exchange Master Agreement, the International Foreign Exchange and Options Master Agreement, and the International Currency Options Market Master Agreement. These documents, endorsed by the Committee, are available on the FMLGs and the Committees web sites, <www.newyorkfed.org/fmlg> and <www.newyorkfed.org/fxc>, respectively. 21 See note 16. Foreign Exchange Committee Page 26
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HUMAN RESOURCES
In this section: How to hire the best employee for your trading operation Why training is an ongoing process The importance of support staff General advice on substance and gambling abuse
Good staffing is a prerequisite for success in the demanding foreign exchange trading and sales environment. It is a primary management responsibility to recruit, develop, and lead capable individuals and effective teams. Trading room employees occupy positions of great trust. The pace of work is intense. Traders operate under strong internal pressures to make profits in a market that is open twenty-four hours a day. At the same time, the process of developing a trader has become compressed. Today, traders are either hired from other institutions or selected internally from staff thought to have the work experience or academic training that would prepare them for trading, sales, and other related activities.
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c) d)
e)
f)
Time-consuming and costly reconciliation of disputed or improperly executed transactions mars the efficiency of the market, hurts profitability, and can impair the willingness of others to trade with the offending institution. Management must be aware of its responsibility to create an operating staff adequate to support the scope of the trading desk's activity in the market. In
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addition, management should ensure that trading is commensurate with available back-office support. It is also essential that management and staff of the back office be sufficiently independent from the traders and trading management in terms of organizational reporting lines. Finally, the incentive and compensation plans for back-office personnel should not be directly related to the financial performance of the trading units.
Compensation
Compensation systems should encourage appropriate behavior that reflects institutional goals and reinforces organizational values.
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OTHER ISSUES
In this section: Why an audit trail is so important Some rules of the road when doing twenty-four-hour trading
Audit trail
Management should ensure that procedures are in place to provide a clear and fully documented audit trail of all foreign exchange transactions and should make every effort to automate the process fully. The audit trail should provide information about the counterparty, currencies, amount, price, trade date, and value of each transaction. Such information should be captured in the institution's records as soon as possible after the trade is completed and should be in a format that can be readily reviewed by the institution's management and by internal and external auditors. Documentation procedures should be adequate to inform management of trading activities and to facilitate detection of any lack of compliance with policy directives. Technological innovations in trading and execution systems have enhanced data capture and allowed for the creation of more precise audit records. Most electronic dealing systems independently generate trade data that serve as an effective audit trail. Trades executed through automated dealing systems provide better verification than trades executed over the telephone. An accurate audit trail significantly improves accountability and documentation and reduces instances of questionable transactions that remain undetected or improperly recorded. Management may therefore wish to take into consideration its audit trail procedures when considering trading room configuration and mechanics for dealing with counterparties. (More information on accounting issues is included in Addendum B to this document.)
Foreign Exchange Committee Page 30
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ADDENDUM A
This addendum offers supplemental information designed to support efforts by financial institutions to understand and manage risk in their portfolios. It includes: various industry-accepted techniques for measuring the amount of market risk, methods and measures used by institutions to establish acceptable limits for market risk, measures used in credit risk analysis, and steps that can be taken by institutions to improve their credit positions.
22
Duration risk is defined as the sensitivity of the present value of a financial instrument to a change in interest rates; beta risk in equities is defined as the sensitivity of an equitys or portfolios value to a change in a broad equity index. Foreign Exchange Committee Page 32
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Value at risk Represents the estimated maximum loss on an instrument or portfolio that can be expected over a given time interval and with a specified level of probability. Stress testing Involves the testing of positions or portfolios to determine their possible value under exceptional conditions. Any assumptions used in stress testing should be critically questioned and should mirror changes in market conditions such as variations in liquidity. Most stress testing models rely on dynamic hedging or some other method to estimate a portfolio's hypothetical response to certain market movements. In disrupted or chaotic markets, the difficulty in executing trades tends to rise and actual market risk may also be higher than measured. Scenario simulation Assesses the potential change in the value of instruments or portfolios under different conditions or in the presence of different risk factors.
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Option limits are nominal limits for each of the Greek risks (the delta, gamma, vega, theta, and rho functions). Liquidity limits restrict the exposure that may occur when an institution is unable to hedge, offset, or finance its position because of volatile market conditions or other adverse events.
23
Additional information on presettlement risk can be found in the Committees 1992 paper, Measuring Pre-Settlement Credit Exposures with Loan-Equivalent Risk. Foreign Exchange Committee Page 34
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ADDENDUM B
This addendum covers: the different types of asset portfolios held by financial institutions, accounting issues relating to derivatives, the accounting treatment of foreign currency hedges, and accounting issues relating to forward transactions.
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An important accounting issue for derivative instruments involves their proper categorization. Institutions should maintain adequate documentation to support the categories they have selected. Inappropriate accounting treatment may affect both income and regulatory capital. Regardless of its designation, a derivative is reported at fair value on a balance sheet. Under SFAS 133,24 derivative instruments are placed in one of the following categories: "No hedge" designation The gains or losses from changes in the fair value of the derivative contract are included in current income. Fair-value hedge The gains or losses from changes in the fair value of the derivative and the item attributable to the risk being hedged are both included in current income. Cash-flow hedge The effective portion of gains or losses in the fair value of a derivative is included in other comprehensive income (outside of net income). The remaining gain or loss on the derivative is included in income.
The Financial Accounting Standards Boards Statement of Financial Accounting Standards no. 133, Accounting for Derivative Instruments and Hedging Activities, was released in June 1998. Foreign Exchange Committee Page 37
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Foreign currency cash-flow hedge The effective portion of the gain or loss on the derivative that hedges a foreign exchange transaction is reported as a component of other comprehensive income. It is reclassified into earnings in the same period or periods in which the hedged foreign exchange transaction affects earnings. The remaining gain or loss in the hedging derivative instrument is recognized as current earnings. Hedge of net investment in a foreign operation The gain or loss on the hedging derivative is reported in other comprehensive income as part of the cumulative translation adjustment to the extent that it is effective as a hedge.
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Collusion between traders who work at institutions that practice NPV accounting methods and traders who work at institutions that do not. The early close-out of a forward transaction (which would be based on a discount value) could result in an immediate and unanticipated gain or loss being realized on the books of a firm that is not practicing NPV accounting methods.
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ADDENDUM C
In this addendum: Supplemental guidance during periods of significant market volatility
This Addendum offers supplemental guidance to market participants in order to promote sound business and fair dealing practices during periods of significant market volatility. The Guidelines and other work of the Committee promote such practices in all trading conditions, although certain practices can be particularly relevant and take on increased importance during periods of significant market volatility. The following guidance highlights these provisions and also finds support in the Trading Principles drafted by a group of leading foreign exchange intermediaries, in response to a recommendation made in the report of the Financial Stability Forum Working Group of Highly-Leveraged Institutions published in April 2000. Effective risk management The Committee recognizes that, as part of effective risk management, all trading parties need to heighten their emphasis of and sensitivity to market risk and credit management issues during periods of significant market volatility. When an individual currency is experiencing high volatility, intermediaries should use particular care when they extend credit to counterparties in such markets. (For further information on best practices for effective risk management, refer to the Risk Management section of these Guidelines on page 20.) Dealings with Market Participants Given the increased potential for confusion and disputes in volatile markets, it is essential that market participants pay close attention to the general expectation (applicable at all times) that they act honestly and in good faith when marketing, entering into, executing and administering trade orders. Market participants should always act in a manner designed to promote public confidence in the wholesale financial markets. Counterparties should satisfy themselves that they have the capability (internally or through independent professional advice) to understand the risks of trading at volatile times and to make independent trading decisions. A salesperson at an intermediary has the right, but not the obligation, to convey economic or market information, trading parameters, the institutions views, and personal views, as well as to discuss with the
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counterparty market conditions and any potentially applicable restrictions relating to transactions. The counterparty should understand that such communications will not constitute investment advice and therefore should not be relied upon, unless this service is specifically contracted for or stipulated in writing. Intermediaries should remain aware that, unless otherwise agreed, an intermediary is not obligated to enter into a transaction with a counterparty under any circumstances. Stop-Loss Orders and Barrier Options Intermediaries should ensure there is mutual agreement with counterparties on the basis on which orders are undertaken, in particular stop-loss orders and barrier options, in order to avoid disputes that may arise in connection with execution of such orders as market liquidity fluctuates. In addition, it would be prudent for a counterparty to take steps to ensure that it independently understands market developments and individual trigger levels if an intermediary has not contractually agreed to be an investment advisor to the counterparty. Execution of Counterparty Orders Handling of counterparty orders requires standards that promote best execution for the counterparty in accordance with such orders, subject to market conditions. Intermediaries should exercise caution in ensuring that internal guidelines are followed at all times particularly during periods of significant market volatility. (For further information, refer to the Ethics section of these Guidelines on page 16.) Publication of Market Research Intermediaries should be attentive to the independence and integrity of any market-related research that they publish. Any views expressed in market research constitute the intermediarys understanding of prevailing markets. Communication of Information Market participants are encouraged to communicate information regarding market developments with each other during times of volatility, with the understanding that each participant providing and receiving information should view it with particular scrutiny given the potential for information being false or misleading during periods of volatility. Market participants should pay special attention to internal guidelines on handling false or misleading information, particularly during periods of significant market volatility. Trading Practices It is important for market participants to adhere to the general standard (applicable at all times) that they not engage in trading practices that constitute fraudulent, deceptive, or manipulative acts or practices under
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applicable laws and regulations, or in practices that violate their institutions ethical rules or any rules of electronic trading systems.
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ACKNOWLEDGMENTS
The Foreign Exchange Committee extends particular thanks to Richard Mahoney of the Bank of New York for his invaluable help in updating the Guidelines for Foreign Exchange Trading Activities. The Committee also expresses its appreciation to the Singapore Foreign Exchange Market Committee, the European Central Bank Foreign Exchange Contact Group, the Financial Markets Lawyers Group, and the Operations Managers Working Group. These groups reviewed drafts of the document and provided very helpful comments and suggestions.